What causes Recessions?


We keep hearing that the Great Recession is over, yet many still remain out of work and many have given up trying to look for work.  There are still extensions being made to unemployment benefits and students are coming out of college burdened with debt and unable to find a high paying job in their field.  Ironically, some of the tactics being used to revive economic activity are actually keeping the recession going.  Today I thought I’d put forth my ideas on what causes a recession.

There are three things that can cause a recession, defined here as a slowdown in the rate of production of goods and services and accompanying losses in jobs and income.  These are:

1) A credit bubble.

2) The spending of resources in a wasteful manner.

3) A decline in the amount of work being performed.

Many recessions involve a credit bubble.  In the 1920’s, stocks were being bought with high amounts of margin, meaning that people were buying hundreds of dollars worth of shares who only had tens of dollars to invest.  In the mid 2000’s, people were buying homes who were not even able to put 1% down and whom could not even pay the interest on the loan.  People were also borrowing more on their homes to pay for vacations, home improvements, and pay for other spending.  This creates the appearance of demand that simply is not there.  As soon as the availability of credit disappears and people have to actually start paying the bills, the whole thing collapses.  It is not so much that jobs and the demand for services have gone away.  It is more that the money to pay for the jobs people had was never there in the first place.

The second thing that can cause a recession is if companies and individuals are forced to spend money in a wasteful manner.  For example, if every farmer were forced to burn half of his crop or if a big storm comes that wipes out a city, the amount of value available to trade for goods declines.   The same goes for things like carbon taxes which require resources but do not create anything of value.  If people are paying double for their electric bills, they will have less money to spend on goods and services.

The third thing is a decline in the amount of work done.  While this may seem backwards, in that a recession causes less work to be done rather than the other way around, if people who were doing something that created value begin sitting at home creating nothing of value, the amount of resources available to pay for things will decline.  When a large number of people are not working, as is currently the case, a recession can drag on for years.  If instead people found something to do that would create things of value they would have funds to spend, which in turn would cause more jobs to be available.  Unfortunately there are not many people who are willing and able to start new businesses and create things without someone else telling them what to create, particularly with all of the laws and regulations that must be learned and followed to do so.  We may therefore be in this recession for a long time.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

2 comments

  1. I also think governments manipulating interest rates can have a big impact. When the economy was hurting after 2001, the government kept lowering interest rates which created less saving and more spending. It didn’t create anything of real value, but just created more debt (mortgages, home equity loans) and less savings.

    Was this a typo? “When people large number of people are not working…”

    • Interest rates can cause economic activity if the problem is that money is not available. It causes waste and inflation when there is no useful place to put borrowed money.

      I’ll correct the typo – thanks.

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